CFM8012a - Accounting for foreign exchange: example of when not to use the cover method

Example: when the cover method can't be used

Watwal Ltd has a French wholly owned subsidiary which experiences a sharp downturn in trading and becomes technically insolvent. The subsidiary has share capital of €500,000; the UK parent subscribes for further shares of €500,000 to enable the French company to pay its suppliers. This equity injection is financed by a €500,000 bank loan. The additional finance does not add significantly to the value of the subsidiary and although Watwal Ltd expects the French business to recover in time, it is unlikely to return to profitability in the short term.

It would not be appropriate for Watwal Ltd to offset exchange differences on the bank borrowing against exchange differences on the new €500,000 shareholding. If the shares were sold, they would not generate enough cash to repay the loan. The loan doesn't function as an economic hedge to the shares - the company is in reality exposed to exchange differences on the loan. The company's accounts wouldn't show a true and fair view if these exchange differences did not go through the profit and loss account.